Sour Reception For Net Lease REIT Merger

It’s being billed as the largest diversified REIT composed of single-tenant leased properties—yesterday’s $1.9 billion merger of Lexington Corporate Properties Trust (LXP) and Newkirk Realty Trust (NKT). Lexington, which owns office and industrial properties in 39 states, gains Newkirk’s mix of properties (particularly retail) and an entré into high-growth markets such as California and New Jersey.

But if it’s a magic combination, Wall Street is having trouble seeing it. LXP shares fell 3.67% yesterday on the news to $20.20 per share. Shares in NKT, meanwhile, dropped by 5.31% to $16.05 yesterday. Both stocks continued to fall during mid-afternoon trading today.

Analysts had many quibbles with the deal, starting with price. The all-stock transaction is valued at roughly $1.9 billion, plus the assumption of $801 million in NKT debt; the enterprise value of the merged entity will be $4.6 billion. While Lexington’s $16.78 per share bid represented a 1% discount to NKT’s Friday (July 21) closing price, BB & T Capital Markets analyst Stephanie Krewson downgraded shares of LXP from buy to hold, citing an inflated sale price and her expectation that the combination with Newkirk will dilute Lexington’s FFO growth. Even though NKT shares were valued below their July 21 closing price, Krewson estimates that the merger price actually equates to an 11.8% premium to Newkirk’s NAV (net asset value), which she estimates to be $15.00 per share. That total assumes an 8.2% average cap rate on adjusted cash NOI.

While Krewson estimates that the deal will raise LXP’s 2006 FFO (funds from operation) per share from $1.90 to $1.94 in 20, she is concerned that 2007 and 2008 could be a different story due to a non-cash amortization associated with NKT’s above-market leases. As a result, she lowered her FFO per share estimates in both years to $1.77 from $1.98 and $2.14 respectively.

Despite the downgrade, Krewson says she does see possible long-term, strategic benefits to LXP shareholders, who will own a company with 352 properties scattered across 44 states (see table) once the deal is closed in the fourth quarter.

Before and After: Lexington’s and Newkirk’s combined portfolio

Property Type

LXP

NKT

Total

Health Care

1

0

1

Industrial

57

14

71

Multi-Use

2

8

10

Office

111

61

172

Retail: Other

19

49

68

Shopping Center

0

28

28

Specialty

2

0

2

Grand Total:

192

160

352

Source: SNL Financial

Krewson and other analysts focused on the disparities between the NKT and LXP portfolios. While NKT has more credit tenants, in some ways it has a riskier portfolio, because many of its retail and office properties are currently leased at above-market rates on short expiration schedules. If tenants don’t re-up at the same rates, which is a risk in trailing markets such as the Midwest, LXP could face a significant reduction in FFO. According to Flagstone Securities REIT analyst Christopher Faems, the weighted average time to expiration on all NKT leases is roughly 4.2 years. In the LXP portfolio, by comparison, that weighted average is more like 7.5 years—enough time to help LXP through a possible down cycle and recovery. Faems sees possible improvement in the overall portfolio in LXP’s plan to spend roughly $500 million in 2007 on acquisitions, which could soften the impact of the pending NKT lease expirations.

On the other hand, LXP will add a larger percentage of investment-grade rental income to its portfolio. Once the deal is closed, LXP should draw roughly 56% of its rents from investment grade tenants (versus just 40% before the merger). For a single-tenant, net lease REIT, investment grade tenants can offer added security. They can also help a landlord defray borrowing costs, which can be driven up by a risky tenant mix. Another upside is that LXP will diversify its holdings, particularly on the retail side.

In a briefing for analysts yesterday, Lexington Corporate Properties Trust CEO T. Wilson Eglin bragged that the merged entity, Lexington Realty Trust, “will have it all” during a conference call yesterday about the deal.

“We are creating what we believe will be the largest pure-play single tenant REIT in a sector [that] is highly fragmented, and where size and scale create very good operating efficiencies,” added Eglin.

Parting Shot: As privatization and merger activity continues to thin the ranks of listed REITs, one real estate attorney believes the remainder of 2006 will see even more consolidation. Martin Luskin, a senior partner at Manhattan-based law firm Blank Rome LLP, was lead attorney on three major REIT deals in as many recent years: DRA Advisors $3.4 billion acquisition of Capital Automotive REIT; DRA Advisors $1.7 billion acquisition of CRT Properties and PL Retails $1 billion acquisition of Price Legacy.

“Many of these companies aren’t interested in getting into bidding wars on one-off asset deals,” says Luskin. “Not only are these deals hard to win, they take a lot of time and energy.”

He says that explains deals like the LXP/NXT merger and increased activity by private equity players like DRA Advisors and Blackstone Group. He also predicts there will be more “club” deals whereby private equity firms team up on highly leveraged acquisitions.

According to SNL Financial, there were $30.62 billion in REIT mergers, acquisitions and privatizations through July 10. In all of 2005, $28.77 billion in similar deals were closed; in 2004, just $5.69 billion.

“There’s still so much money out there looking for a home in the private equity world,” he says. “That will drive more REITs to go private or merge over the next few months.”